Climate bonds
Climate bonds

Climate bonds

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TL;DR

  • Climate bonds are a type of debt financing that allows corporations and governments to raise funds for climate adaptation and mitigation projects, without giving up ownership.
  • Government, aka sovereign, bonds have great potential to drive climate action forward, especially in emerging markets.
  • To prevent greenwashing and ensure projects move forward as promised, the market needs transparent and consistent standards that are easy to track and comparable across different markets.

A brief introduction to bonds

Bonds are a type of debt financing issued by governments, corporations, and other organizations as a way to raise money. When an investor buys a bond, they essentially loan money on the promise that it will be paid back by the issuer within a fixed period and with interest.

Instead of borrowing a large sum from one lender, smaller sums are raised from a pool of many investors. Bonds have the benefit of being temporary, so a company is not giving up any permanent equity in order to raise funds. There are essentially two types of bonds based on the “creditworthiness” of the issuer:

  • Investment grade bonds: Issuer has a strong credit rating and low risk of defaulting.
  • High-yield bonds (aka junk bonds): Higher risk of the issuer defaulting, so a higher interest rate is offered in compensation for investors taking that risk.

Climate bonds

Climate bonds are a type of green bond. Green bonds are earmarked for environmentally friendly projects such as renewable energy, energy efficiency, sustainable agriculture, clean transportation, and pollution prevention. Climate bonds are specifically issued to finance projects that address climate change and its impacts, so the focus is not just on sustainability but also on reducing emissions and building resilience to the effects of climate change.

There is no guarantee that the project being financed will be green, except that interest rates are usually tied to targets, so there is a financial penalty if the seller is not achieving their goals. Overall, the “greenness” of the bond is voluntary, and there is no universally accepted system of certification and validation for these projects.

The first green bond, “The Climate Awareness Bond” or CAB, was issued in 2007 by The European Investment Bank (EIB). The CAB set the standard for green bonds and raised $600 million to be used towards renewable energy and energy efficiency projects.

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The World Bank is a major issuer of green bonds. From 2008 to 2022, it issued over 200 bonds, equivalent to approximately $18 billion.

Sovereign bonds

Sovereign bonds are those issued by the governments of a country to raise money for various projects. The overall sovereign bond market is much larger than the private bond market, but the reverse is true for green bonds. Still, sovereign green bonds make up more than 20% of the Bloomberg MSCI Green Bond Index*, up from 7% at the end of 2017.

Sovereign green bonds have massive potential to push forward climate action and sustainable development agendas, but progress on the commitments can be difficult to track. The same kind of ESG data that would be available to track progress for a company is not available at the country level, and investors primarily rely on self-reported data.

Source:
Source: MSCI, 2023
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As of 2022, the top three sovereign green bond issuing countries were: China ($85.4 billion), the US ($64.4 billion), and Germany ($61.2 billion).

*The Bloomberg MSCI Green Bond Index was created in 2014 to evaluate green bonds. To be included in the index, a bond must meet a set of inclusion criteria, including a minimum issue size ($300M) and adhere to “established Green Bond Principles.” Approximately 83% of self-labeled green bonds are included in the index.

For developing countries

The countries in most need of sustainable development financing may also find it more difficult to raise those funds as their developing economies can be seen as unstable, especially as the effects of climate change worsen. However, in selling green bonds, those countries are more likely to be able to better adapt to and prepare for the effects of climate change, thereby making their economies less fragile to those effects.

According to a 2022 survey by the World Bank, investors identified six challenges to investing in the emerging sovereign thematic bond market (including green, social, and sustainability bonds):

  • Weak frameworks - the market requires consistent and comparable standards across countries.
  • Lack of institutional capacity - bond issuance and compliance require many steps and cooperation between numerous different levels and institutions within a government.
  • Limited data availability - more robust performance tracking is needed.
  • Macroeconomic and market conditions - emerging economies have a higher risk of default.
  • Transaction costs with local currencies - most countries prefer to issue bonds in local currencies, and some investors argue this eats into returns.
  • Low liquidity - low issuance means not enough diversity in the market.

Nationally Determined Contributions (NDCs)

Under the 2015 Paris Agreement, each country was required to make a summary of its climate action plan for post-2020 called the Nationally Determined Contributions (NDCs). The NDCs are set by each country to define the specific actions and targets they will undertake to reduce GHG emissions and limit global warming to “well below 2°C.” The NDCs are based on the individual circumstances, priorities, and capabilities of each country, and expected to be updated every five years.

So far, none of the NDCs are on target, and a lack of financing has been listed as a key barrier here. One 2017 estimate put the financing needed by the original NDCs somewhere between $97 and $191 billion, but up to 5-6x higher to realistically hit a 1.5°C target. Green bonds are one of the available funding mechanisms to help countries meet the NDCs.

Climate Bonds Initiative

Founded in 2009, the Climate Bonds Initiative (CBI) is an international nonprofit organization that works to mobilize the bond market as a financial mechanism to address climate change. The organization works to develop standards and guidelines, conducts research, and reports on the green bond market.

Climate Bonds Standard and Certification Scheme

A voluntary labeling scheme designed by the CBI. Certification under the Climate Bonds Standards is designed to show the following:

  1. The issuer is fully aligned with the Green Bond Principles and/or the Green Loan Principles
  2. The issuer is using best practices for internal controls, tracking, reporting, and verification
  3. The issuer is financing assets that are consistent with achieving the goals of the Paris Climate Agreement

Issuers are validated by approved third-party providers, and they must report back annually to maintain their certification. Follow-on reporting is made available to the public, and failure to comply or maintain certification can result in reputational and financial costs to the issuer. For example, if the issuer charged a green bond premium*, they may be required to compensate their investors for the difference in yields between that bond and comparable non-green bonds.

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*Green bond premium: The difference in price between a green bond and a conventional bond issued by the same issuer with similar terms and maturity. Investors are sometimes willing to pay this premium because of the positive effect the financing will have on the environment and society.

Climate Bonds Taxonomy

The Climate Bonds Taxonomy provides an overview of climate mitigation and adaptation opportunities and serves as initial screening criteria for labeling bonds as green under the CBI.

Policies and Incentives

More carrot than stick. Here is a small selection:

  • EU European Green Bond Standard: A provisional agreement was reached in early 2023 that aims to reduce greenwashing by requiring issuers to align bonds to the EU Taxonomy (with a 15% “flexibility pocket” for activities not covered by it). This will become mandatory 12 months after it is formally adopted.
  • United States (tax incentives)
    • Tax credit bonds: Investors receive tax credits instead of the issuers paying interest.
    • Direct subsidy bonds: Issuers receive subsidies to help with interest payments.
    • Tax-exempt bonds: Investors do not pay income tax on interest generated.
  • China offers guarantees and subsidies for green bonds at the national and local levels.

Resources

Last updated: Oct 2023